Vonage finds Street a lonely place

Analysts at firms that managed IPO put stock on hold

WASHINGTON (MarketWatch) -- The underwriters who managed the initial public offering of Vonage Holdings Corp. valued the company at $17 a share, but the brokerages' own stock analysts say the Internet phone company is worth no more than $9 to $11 a pop.

In the past few days, analysts at CitiGroup, UBS and Piper Jaffray, which handled the Vonage IPO, initiated coverage on the stock with hold or neutral ratings. While the brokerages took pains to suggest Vonage could eventually justify a higher price, they added a lot of ifs, ands and buts.

UBS analyst John Hodulik, for example, said "the Vonage business model works and will continue to work far longer than most observers believe it will." Yet he also acknowledged that the "risks for Vonage are high" given a number of factors that could negatively affect sales growth and future profitability.

Some of those factors include stiff competition, the high expense of acquiring phone customers, sudden legal difficulties and the threat of new federal regulations that could jack up Vonage's costs.

Since Vonage
VG, +2.64%
went public in late May, investors have put far more weight on the negatives. As a result, the stock has slumped 55% to as low as $7.67 in Friday trades.

Of course, it should be noted that the goal of the underwriters is to maximize the amount of money a company raises in an IPO. The firms' stock analysts cater to a different audience and operate under separate guidelines. Still, their coolness toward Vonage should serve as a caution to all investors.

Lots of doubters

Skepticism about Vonage was already running high before its disappointing IPO, whose value dropped 13% on its first day. While many industry observers praise the company's Internet-phone service, low prices and aggressive business plan, they aren't sure whether the company can ever turn a profit.

Since its inception five years ago, for example, Vonage had lost $300 million -- and counting -- and the company is not expected to achieve earnings from operations until at least 2009. Over the next few years, Vonage is expected to spend an average of more than $250 to obtain each new subscriber, who typically pays about $25 a month for service.

What's more, the company is still a Lilliputian in a land of giants. While Vonage has gained an impressive 1.6 million customers -- easily tops in the fledgling Internet-phone market -- large phone companies still control the bulk of the market. They also offer their own Internet-phone plans, though they do not market them heavily.

Big cable companies, meanwhile, are quickly moving into the phone market and most now offer relatively cheap Internet-calling plans, at least to some of their customers. At the bottom, free services such as Skype, now owned by eBay Inc., could nip at Vonage's heels.

The likely effect is that prices for phone service of all types, including Internet telephony, will continue to decline.

"Other telecom services have consistently experienced pricing erosion -- long distance cellular and DSL for example -- and we would anticipate the same for the [Internet calling] market," Piper Jaffray analyst Troy Jensen wrote.

Fresh concerns

Other problems have cropped up since the IPO. For starters, the company's program to sell some shares directly to customers backfired. Vonage now faces several suits alleging that it did not provide sufficient or fully accurate information to investors.

Several rivals, meanwhile, have sued Vonage on charges of patent infringement, the most prominent being Verizon Communications. Any prolonged legal battle could be costly, analysts note.

Wall Street has also questioned the company's continuation of a program to give a free month of calling or a six-month introductory rates of $20 to new customers. And to prevent old customers from leaving, Vonage is reportedly cutting rates for them as well.

"In our view, preserving the customer is the right strategy given the high cost per gross addition, but the extent of the price increase is a concern," Citigroup analyst Michael Rollins told clients.

Long-term success?

Despite all the caveats, the analysts suggested that Vonage could eventually pan out as a successful investment if the company continues to grow rapidly while learning to contain its costs.

By the end of 2008, UBS estimates Vonage could top 5.4 million lines in service, with revenue surging to $1.5 billion annually from a projected $626 million in 2006.

The catalyst behind such growth would be Vonage's attractively priced calling plans and leading brand name.

The average Vonage customer pays about $25 a month for unlimited local and long-distance calling as well as a host of features such as call waiting and caller ID. By contrast, most other phone suppliers charge rates that average from $35 to $65 a month, Citigroup figures.

Vonage has also spent a tiny fortune on Internet advertising and traditional media to build an industry-leading brand. The company is a lead sponsor of the World Cup soccer games seen on ABC and ESPN.

At the same time, Vonage sells its products in the stores of a number of leading retailers such as Best Buy, Circuit City and RadioShack. Vonage service can now be purchased in over 10,000 locations.

Unlike big phone and cable companies, moreover, Vonage spends far less on capital equipment since it doesn't own a network. Customers buy an adapter that plugs into a high-speed modem and their calls travel over the Internet.

In the long run, analysts say, the cost advantage should work in Vonage's favor barring any unfavorable regulatory rulings or attempts by network operators to constrict its service.

For now, though, Citigroup, UBS and Piper Jaffray are all telling their investors to sit on the sidelines. They say trading in Vonage is likely to remain quite volatile until the company shows improvement in subscriber growth and cash generated by each customer.

"Based on our current assumptions, we believe Vonage's model works, but we need to see improvement in its key metrics," Hodulik of UBS wrote.

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